Solving the structural problem of Chinese bonds

Holders of Kaisa’s offshore bonds face an uncertain future after Sunac abandoned its takeover offer for the troubled Chinese­­ property company. While the negotiations rumble on, investors should be paying close attention to the issue of structural subordination in US dollar bonds from Chinese businesses.

In every jurisdiction, whenever a holding company raises debt, it is structurally subordinated to the operating subsidiary’s liabilities. Two of the most important remedies for structural subordination are a guarantee from the operating subsidiary and a charge on the operating company’s assets.

But Chinese holding companies are often incorporated outside China, and when they borrow offshore, the onshore operating companies are not allowed to provide guarantees or pledge their assets as security.

This makes China a unique jurisdiction, where structural subordination for offshore debt is baked into the deal by regulatory restrictions. Unfortunately for investors, this format is the most common structure for Chinese companies looking to access international debt.

From the early days, nearly 15 years ago, investors have accepted structural subordination in offshore Chinese bonds. Many companies have issued – and have successfully refinanced – offshore bonds. Rating agencies notch down the offshore debt if the onshore debt exceeds a certain level (15%–20% of assets, or 2x Ebitda). And life goes on.

SEVERAL PROBLEMS ARISE from this structure. One issue is that the onshore creditors of the operating subsidiaries get priority in a distressed situation. Onshore debt is often substantial, particularly for Chinese property companies, since they take large construction loans from onshore banks by pledging different properties. That is why several onshore banks have been able to file suits to freeze Kaisa’s assets, while offshore lenders have been left watching powerlessly.

Second, the ability to refinance offshore debt becomes crucial. The offshore issuers are able to pay interest out of dividends from their onshore subsidiaries, but are dependent on refinancing for the repayment of principal, since repatriation of equity funds from onshore subsidiaries requires a lengthy and difficult approval process.

The third problem is that offshore lenders are exposed to subsequent financing decisions, since companies may be able to raise the share of onshore debt in their capital structure and push the offshore lenders deeper into subordination.

Another structure has emerged to allow China-incorporated companies to raise offshore debt without needing the approval of China’s foreign exchange regulator. In this case, the onshore holding company signs a “keepwell” deed, promising to ensure that the offshore SPV that raises the debt will have enough liquidity to service its obligations. It may also sign an equity interest purchase undertaking, promising to purchase some onshore equity interests in order to transfer enough money offshore to pay back the bonds.

However, the robustness of this structure has yet to be tested in practice. Investors’ ability to enforce these agreements is subject to several regulatory approvals from China and hence may fail when the time comes. In any case, claims under these agreements will be subordinated to the onshore company’s secured borrowings.

Last year, China opened a window for onshore companies to provide guarantees or pledge security for offshore debt, but this was subject to a restriction that the funds must be used offshore. Perhaps because of this requirement, there has been a very limited take-up of this structure, even though it is more secure for the offshore investors.

The structural problems assume an added importance when we consider that China has become a much bigger part of Asia’s US dollar bond market. In the closely followed JP Morgan Asia Credit Index, China’s share was in the single digits until 2010, but has soared in the last four years to 34% of all outstanding bonds. In terms of new issues, China’s share used to be 5%–10% between 2005 and 2009, but has since exploded to 55% last year, according to our database. That leaves a large chunk of every investor’s portfolio exposed to the structural subordination issue.

DO WE HAVE any practical means of alleviating these concerns? One useful idea would be to incorporate an offshore reserve account with a portion of the bond proceeds, to cover perhaps six months of interest payments. This would enable a stressed company to continue servicing the bonds without triggering a default, giving an opportunity for potential bidders for the business to emerge. In a situation where competing bidders may raise the recovery value for the bondholders, this period may prove invaluable. We have seen such reserves previously in Indonesian deals: why not bring them to China?

Financial covenants could also be tightened. The terms of offshore bonds usually restrict the amount of onshore debt that can be raised by subsidiaries to 15% of total assets, but the definition of debt often excludes bonds, debentures and other capital-market instruments. This exclusion leaves room for large onshore subsidiaries to raise debt from the onshore bond market, raising the level of subordination for offshore creditors.

Other potential areas for tightening could include the maintenance of a company’s listing status, and the ability to declare default in case the stock is suspended from trading for a prolonged period.

While no lending structure can remedy underlying weakness in the business or corporate-governance failings, investors should not give up on hope of better structures. As long as we are concerned by the structural subordination problems in China, it is time to think about potential solutions, too.

*Dilip Parameswaran is founder and head of Asia Investment Advisors, an advisory firm specialising in Asian fixed income.

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A glut of weak trading debuts and a delayed listing have rocked India’s IPO market, dashing hopes that improved access to capital would help restart the country’s investment cycle. Sadbhav Infrastructure Project was forced to delay its IPO and slash its Rs9bn (US$140m) target last week after a poor response from investors. That capped a disappointing month for Indian listings, with three newly listed companies slipping on their debuts this month. Bankers had hoped that the successful listing of Indian wind-turbine maker Inox Wind in April would reopen the Indian IPO market, but waning demand for Indian equities has taken its toll. Slower-than-expected economic reforms, weak corporate earnings and uncertainty over global interest rates have taken the steam out of India’s stock market in recent weeks. As of May 28, the benchmark Sensex index was down 8.7% from an all-time high of 30,024 on March 4. Infrastructure construction company PNC Infratech, which raised Rs4.9bn from an IPO, slid 4.5% on its National Stock Exchange debut last Tuesday, closing at Rs360.50 from its offer price of Rs378.00. Although the shares rebounded to Rs402.80 the following day, PNC was the third firm to post a weak debut in May, after UFO Moviez and MEP Infrastructure. On the same day, Sadbhav Infrastructure Project delayed its planned Rs9bn IPO after failing to get the valuations it wanted. Sadbhav Infastructure has filed a revised prospectus for a much smaller deal. It will now sell Rs4.3bn of new shares, down from an original target of Rs6bn, while investors Xander Investment Holding XVII and Norwest Venture Partners will sell a combined 12.9m shares, down from 32m originally. Lower valuation Sadbhav Infrastructure’s IPO was first unveiled at the height of the euphoria that followed Narendra Modi’s election as prime minster last May. Parent Sadbhav Engineering successfully raised Rs2.5bn through a qualified institutional placement in October and the shares have risen 33% since then. “It (Sadbhav Engineering) wanted to ride on the success of its share price, but the market was unwilling to pay the price,” said a banker away from the deal. Sadbhav Infrastructure has also reshuffled its syndicate, dropping Citigroup and Yes Bank in favour of Macquarie. Edelweiss, Inga, ICICI Securities and Kotak remain. While the company and the banks concerned refused to comment on the move, bankers away from the IPO said the slow execution forced the company to change the banks. The timing of the revised IPO is unclear at this stage. Bankers, however, remain optimistic and expect a better crop of IPOs in the second half, pointing to expectations of rate cuts from the Reserve Bank of India and a clearer picture on global interest rates. These factors could spur a recovery in Indian stocks. Upcoming IPOs include the US$150m float of contract research company Syngene International, a unit of Biocon. Lead managers Axis, Credit Suisse and Jefferies are currently premarketing the deal. Dilip Buildcon plans to launch its US$150m IPO at the end of June. The IPO will comprise Rs6.5bn of new shares, 3.5m shares from the controlling shareholders and 11.4m from Banyantree Growth Capital. Axis Capital, Deutsche Bank and PNB Investment are the bookrunners. Navkar Corporation also plans to launch its Rs6bn IPO in the third quarter. Axis Capital, Edelweiss and SBI Capital Markets are the bookrunners.

Australia and New Zealand Banking Group received a robust response to its inaugural Green bond offering on Wednesday, but some observers said the fledgling market was unlikely to develop quickly without any pricing advantages for issuers. There was nothing wrong with the execution of the A$600m (US$458m) five-year deal, Australia’s biggest Green bond to date and the biggest senior bank bond so far this year in Australian dollars. Australia’s state-owned Clean Energy Finance Corporation provided a cornerstone commitment of up to A$75m for the bond, but this was not required as 46 private sector investors made for an order book of A$725m. Around a fifth of these investors (mainly councils, middle market and ethical funds) purchased ANZ bonds for the first time, buying about 7% of the deal. Australian accounts were allocated 92% of the bonds and Asia 8%. Asset managers took 56%, insurance companies 21%, middle market 7%, banks 3%, local councils 3%, central banks 3%, state governments 3% and private banks 1%. Aa2/AA–/AA– rated ANZ’s 3.25% June 3 2020s priced at 99.384 for a yield of 3.385%, equivalent to 80bp over asset swaps, equalling the three-month plus 80bp margin for identically rated National Australia Bank’s A$1.9bn floating-rate sale a day earlier. Ultimately, however, the Green market may need investors to pay a “good cause” premium over conventional bonds to persuade more issuers to access the sector and help it take off. In a report issued on the day of ANZ’s debut, Moody’s senior vice president Falk Frey cited the lack of pricing benefits over standard bonds to help explain this year’s drop in the issuance levels of companies and municipalities, which sold 46% of 2014’s US$37bn total. Nevertheless, Frey predicted further overall growth in the global Green bond market from 2015’s expected US$100bn supply as more issuers emerge, particularly in countries like China and India, which were edging towards more eco-friendly economies. Catching up Australia has lagged offshore markets as ANZ is only the fourth Australian dollar Green or Climate bond issuer and the second bank after NAB, which priced a 4.0% A$300m seven-year MTN on December 4 2014 to yield 100bp over swaps. The other two trades were from Triple A rated sovereign, supranational and agencies. International Bank for Reconstruction and Development (part of the World Bank Group) was the first to print a Green Kangaroo on April 16 last year with a 3.5% A$300m five-year bond and Germany’s KfW followed on March 25 this year with a A$600m 2.4% 5.25-year sale. An Australian origination banker said he had been working closely with one potential corporate issuer and pointed out that local property group Stockland, rated A– (S&P), sold a €300m (US$327m) seven-year Green Eurobond last October. “For many Australian corporations, Green bonds are a good fit because they have natural green assets that can be ring-fenced for these instruments,” he said. “As far as pricing is concerned, I do not expect a differential to develop between Green and standard bonds, with the growth of the Green market likely to happen naturally as more investors participate in a widening array of Green-specific projects.” ANZ worked with third-party verifier Ernst & Young and the Climate Bonds Initiative to identify A$1.1bn of ANZ loans made to wind farms, solar energy firms and green buildings in Australia, New Zealand and parts of Asia that met the CBI’s Green criteria. Proceeds from the bond will finance this portfolio of loans and will also be allocated for investment in future green projects, potentially including geothermal power and fuel efficient transport sectors.

Taiwanese lender Bank SinoPac is seeking a meeting with senior management of Hanergy Thin Film Power Group’s parent company after a precipitous 47% drop in the Hong Kong-listed company’s stock price. SinoPac, as facility agent on a US$82m syndicated loan for affiliated company Hanergy Capital, has requested a meeting between the lending syndicate and the chairman and senior finance directors of Hanergy Holding Group, the borrower’s parent. The May 21 request came a day after heavy selling wiped out nearly half the market capitalisation of Hanergy Thin Film, and seeks clarification on the company’s trading suspension. The US$82m loan, signed in December, is secured against a standby letter of credit (SBLC) from Export-Import Bank of China (Chexim). “Our head office is very worried about the current situation and is concerned about the company’s ability to repay the loan. The worst-case scenario would be that Hanergy would not be able to repay the loan. However, the SBLC can compensate for the loss,” said a banker at one of the lenders. Hanergy Capital is a unit of Hanergy Holding, a Beijing-based renewable power generation company. In December, Hanergy Capital sealed the 3.5-year bullet term loan, which paid a top-level all-in pricing of 276bp, based on a margin of 250bp over Libor, attracting 10 other banks from China, Korea, the Middle East and Taiwan in general syndication. ICBC Asia joined Bank SinoPac as MLAB, while Chang Hwa Commercial Bank Hong Kong, China Everbright Bank Hong Kong, Doha Bank, Far Eastern International Bank Hong Kong, Hua Nan Commercial Bank Hong Kong and Woori Global Markets Asia were MLAs. Bank of Panhsin, Land Bank of Taiwan Hong Kong and Taiwan Cooperative Bank also participated. Hanergy Thin Film is under investigation from Hong Kong’s Securities and Futures Commission after its shares surged five-fold since September in the run-up to the May 20 crash. In a statement on the following day, the company said it was not aware of any reason for the collapse in the share price and that the group’s operations were normal in all respects. It added it was in a good financial position with no overdue loans. At its peak price in March, the company was worth US$48bn, more than its nearest two dozen rivals combined, making founder and chairman Li Hejun one of China’s richest men, even as analysts and market watchers questioned the validity of some of the company’s bullish proclamations. China concerns The developments related to Hanergy Thin Film put the spotlight once again on corporate governance issues in China that have increased the risks of lending to companies there. On May 21, the day that Bank SinoPac sent its letter to Hanergy, another Chinese borrower announced that it had lost track of its chairman. Syndication of a US$132.8m loan for Chinese department store chain Century Ginwa Retail Holdings was put on hold after the Hong Kong-listed company announced that it had been unable to reach its chairman and executive director, Wu Yijian, for more than six days. Also on the same day, Chinese bathroom appliances maker Joyou said it would file for insolvency and had fired its chief executive and chief operating officer. The Frankfurt-listed company had said earlier it might need to file for insolvency because it expected a writedown on its holding in Hong Kong Zhongyu Sanitary Technology (Joyou Hong Kong) to cause a big loss. Last July, Joyou sealed a US$300m five-year loan with Bank of Tokyo-Mitsubishi UFJ, Mizuho Bank and Sumitomo Mitsui Banking Corp. Repayment of part of the loan was to begin on October 31 2015. Earlier this month, Hong Kong-listed Sound Global dodged a wider default after prepaying a US$110m loan in full. The Chinese waste-water treatment company’s prepayment followed a share suspension on March 16, when the privately owned company delayed publishing its 2014 annual results. In late April, Hong Kong-listed Chinasoft International entered into negotiations with lender

Taiwanese life insurance firms have cooled their frenzied bond buying, after record monthly purchases sapped cash balances and pushed them close to permitted trading limits. Foreign currency issues in Taiwan have surged this year as firms from Goldman Sachs to AT&T have taken advantage of rampant demand from yield-hungry local insurers. Recent new issues, however, have met a more measured response. According to senior officials at Taiwanese asset managers, as well as bankers who recently marketed bonds there, life insurers have become more selective in their purchases as their ability to buy new bond issues has shrunken significantly. “Many insurance companies have used up their trading limits. So, they don’t have much room to buy. Many hit their limits after the Deutsche Bank deal this month,” said Ray Cheng, head of rates and credit trading at SinoPac Securities. The Deutsche deal was a Rmb1.65bn (US$266m) 5-year Formosa that priced at 4.3%. “They aren’t buying as much as they used to and have to look for other options. They are lobbying the Financial Supervisory Commission to buy more, but negotiations are ongoing.” In May 2014, the FSC ruled that bonds issued in foreign currencies in Taiwan, known as Formosa bonds, would no longer be considered part of the 45% overseas investment cap. With five-year local government bonds paying 1.01%, life insurers have been eager buyers of higher-yielding foreign currency assets. While the reform helped them buy more Formosa bonds, there are still limits on how much they can buy from one issuer and one sector. Almost every Formosa bond to date has been from the financial sector and some related issuers, such as Deutsche Bank, have issued multiple Formosas. Figures from the Taipei Exchange show that bond trading volume in Taiwan hit NT$1.273trn (US$41.5bn) in March, the busiest month since May 2013. Volume in January was not far behind at NT$1.22trn. However, in the intervening month, trading plummeted. In February, it fell to NT$436.42bn and, in April, it came in at NT$912.75bn. Cheng added that this heavy buying has pushed yields down, and with no Central Bank rate hike on the horizon, Formosa bonds have become less interesting. Bankers who worked on a recent bond issued out of Hong Kong that had heavy take-up from life insurers, some of which were Taiwanese, described numerous conversations with officials who told them that the cash simply was not there anymore. “Their cash levels are running much lower than before,” said a Hong Kong-based syndicate banker. “We’ve had a lot of conversations with them, and they have been buying a lot since the start of the year, but they’ve been very frank and said they can’t keep buying like they have been because there is less cash available. They had been buying anything close to 4% (yield), but now it’s going to take a lot more to get them to invest.” A number of foreign banks recently applied for licences to sell offshore products in Taiwan, believing that the Formosa market will become increasingly important. While they are rightly chasing what had been one of the more buoyant markets in Asia, they could arrive to a much quieter scene than anticipated. There is optimism however that lobbying efforts with the FSC will be successful. The FSC has stated its clear intention to expand the Formosa market, so market participants believe that ultimately it will loosen investing rules further.

India’s plans to allow domestic firms to raise rupee-denominated debt abroad for the first time are being eclipsed by the rising cost of funds in international markets, making it harder for cash-starved businesses to take advantage of the relaxed rules. A weakening rupee and foreign investors’ cooling appetite for Asia’s third-largest economy have added to the cost of accessing funds overseas in recent months. In early April, the Reserve Bank of India said it will allow Indian companies to raise rupee-denominated debt offshore – known as “Masala bonds” – but it has yet to issue the final guidelines. While the move is being viewed as a step towards full currency convertibility, and potentially even lowering the cost of capital that is among Asia’s highest, bankers say that firms may be discouraged by the high premium sought by foreigners. Indian Railway Finance Corp, the finance arm of state-run Indian Railways is one of at least 10 companies that have confirmed plans to tap this offshore local currency bond market, and is likely to be first off the block. “We have to see the appetite and time the issue accordingly,” said IRFC managing director Rajiv Dutt. “Pricing is an important factor.” Bankers say a top-rated Indian corporate would in current conditions have to fork out around 9% on a 10-year offshore rupee bond when forex swap and withholding tax are taken into account. This is around 60bp–65bp higher than borrowing from the domestic rupee market, up from a premium of 35bp–40bp some three months earlier, according to several bankers who spoke on condition of anonymity. The final cost will also depend upon the extent to which an investor wants to hedge the rupee, depending on the currency outlook. Weak rupee, slow reforms The prospect of further currency weakness and disappointment over the slow pace of reforms could drive up funding costs even higher – meaning issuers could be put off for now. The backdrop of weak corporate earnings and falling export receipts have sent the Indian rupee down as much as 1.5% in the last month and foreign investors have sold US$2.03bn in stocks and bonds. “Allowing INR-denominated bonds for investment by foreign investors is a welcome move and is seen as a small step towards internationalisation of the currency, but it is unlikely to be a big hit until growth picks up and the view on the currency improves,” said Manoj Rane, managing director and head of global markets at BNP Paribas India. So far, only the Asian Development Bank and the International Finance Corp, an arm of the World Bank, have issued Masala debt, allowing investors’ to access rupee debt outside India last year. “Demand from investors will be more driven by the macro view on India,” said Rakesh Garg, managing director, global finance, Barclays India, adding India’s current high-profile tax dispute with foreign investors would also weigh. “Tax is a big issue in the minds of investors. They want certainty on tax rates at least during the tenor of the instrument.”

Sunac China Holdings last Thursday called off its planned acquisition of Kaisa Group Holdings, in a move that leaves recovery prospects uncertain for the troubled developer’s offshore bondholders. Sunac said it had called off the bid because “certain conditions precedent” could not be met. It had agreed to acquire a 49% stake in Kaisa in February, subject to the successful restructuring of the latter’s obligations, among other conditions. The acquisition, however, had been in doubt since Kaisa chairman Kwok Ying Shing resumed his duties and Shenzhen authorities lifted restrictions on the company’s sales. Reports said that several of Sunac’s staff had been forced to leave Kaisa’s offices after Kwok returned. Kaisa had said in March that it expected to run out of liquidity in the first half of 2015, and Thursday’s move raises questions over how it will repay its debts without Sunac’s investment. On Thursday, Moody’s lowered the outlook on Kaisa’s Ca corporate and debt ratings to negative from positive. “The termination of the share-purchase agreement will weaken repayment prospects for Kaisa’s creditors, including its offshore bondholders,” said Franco Leung, a Moody’s vice president and senior analyst. Kaisa had initially offered offshore bondholders a restructuring scheme worth around 50 cents on the dollar, in which it would slash the coupons on its US$2.5bn offshore bonds and had the option to pay distributions in kind until 2017. However, bondholders had pushed for more, despite the traditionally poor recovery prospects for holders of offshore bonds issued by Chinese companies, and Reuters reported earlier this month that a steering group had been in discussions for an offer worth around 65 cents. One Kaisa bondholder was hopeful the latest development might mean a higher offer to bondholders from Kwok, and said that Sunac’s offer for Kaisa’s shares had looked low in the context of recent Chinese share gains. “Given the onshore equity rally, the price negotiated is way too cheap,” he said. Better offer Analysts said the collapse of the acquisition was not a surprise. “I think most people in the market expected Sunac to lose patience,” said Christopher Yip, a credit analyst at Standard & Poor’s. “Sunac is losing an opportunity to expand into Shenzhen, but at the same time they are recuperating some of their cash that they can deploy elsewhere. The cash that they are recuperating back does not seem likely to be used for debt repayments, so we think they are still likely to use it for expansion.” On Tuesday, S&P cut Sunac’s rating to B+ from BB– on weakening cash flows and increasing leverage. Yip said any new offer to Kaisa’s offshore bondholders was likely to be better than the terms they had been offered as part of Sunac’s acquisition. Kaisa defaulted on coupon payments for its offshore bonds due 2017 and 2018 in April, but had been struggling since Chinese authorities blocked its sales late last year. Chairman Kwok resigned in December, and his departure on December 31 breached the terms of a loan, sending the bonds into freefall. Kaisa’s bonds were bid as low as 25 in January, but rebounded on news of Sunac’s white knight bid. Kaisa’s offshore bonds fell three points in early trading on the news, but quickly rebounded to close unchanged or slightly up for the day, with its 2018s seen at 62.6/64.9 at the end of the session. A high-yield trader said there was not much trading in Kaisa bonds, with most of the selling coming from small private bank accounts. Counterintuitively, Sunac’s share price fell 5.7% on Thursday after the announcement, though its April 2018 bonds jumped more than a point, to 102.9 from 101.6. The mainland China stock market slumped 6.5%.

Evergrande Real Estate dragged a HK$4.65bn (US$600m) top-up placement across the finish line last Thursday after finding itself caught in a plunging stock market. Evergrande sold the shares at an 18% discount to Wednesday’s close, a much deeper discount than it had planned, but it was not enough to prevent the stock from plunging 27% after trading resumed last Friday, ending the week at HK$5.05. While the company got its money, its experience offered a painful reminder of the risks attached to follow-on offerings in a volatile market. Evergrande invited banks to bid for the follow-on last Wednesday but left it too late to launch the deal that day. Instead, it suspended trading the following morning to give it more time to negotiate with its banks and complete the placement. The company could hardly have picked a worse time, but bankers had already been gauging demand for the deal and it had little choice but to go ahead. Hong Kong stocks fell 2.23% that day, mirroring a 6.5% plunge in Shanghai on concerns that China’s central bank was tightening liquidity and more brokerages were tightening margin financings. Shares of Hong Kong-listed Chinese property developers generally fell more than 3%. Evergrande launched the sale of 748m shares at an indicative price range of HK$6.22–$6.36 on Wednesday morning, but was forced to restructure the deal. It decided to sell 820m shares, or 5.25% of its enlarged share capital, at a fixed price of HK$5.67 each. The final price represents a discount of 18% to the pre-deal spot, much deeper than the original target of 8%–10%. The shares were sold to about 10 investors, including institutional investors who had indicated sizeable orders before the deal launched, and ultra-high net worth individuals. Friday’s plunge in Evergrande’s shares raised questions about why the company had pushed the deal ahead in such poor market conditions. “Even if they cancelled the placement, the shares would still drop as everyone now knows the company wants to do a US$600m placement. They have to move fast, or other property developers will rush to the market for funds,” said a source close to the deal. “The company was very determined in completing the placement, and doesn’t mind clearing the deal with a big discount,” the source added. Evergrande’s banks also dodged heavy losses after agreeing to work on the deal only on a best-efforts basis. JP Morgan was close to the deal at one point but withdrew due to some internal issues. Before the US bank’s departure, all firms on the deal had been asked to hard-underwrite the share sale. Citic CLSA, Credit Suisse and Haitong Securities International were the joint bookrunners on the deal. Jefferies was the joint placing agent. There is a 90-day lock-up on the vendor and issuer. The lock-up, however, comes with a carve-out to allow the placement of not more than 10% of Evergrande’s issued share capital to a financial institution, which will then be subject to a 12-month lock-up period.

Index provider MSCI will decide on June 9 whether to include A shares in its global emerging-markets benchmark, potentially triggering an international scramble for PRC securities. Market participants see the inclusion of China’s A shares in the MSCI index, the benchmark for funds managing over US$1trn globally, as a necessary spur for more rapid financial markets liberalisation in the world’s second-largest economy. Should the shares get the green light, more EM funds than ever will have to buy securities in the US$3.9trn onshore market to match the index’s new China-weighted composition. MSCI already charts the performance of PRC shares via its China A International Index, but it has yet to include them in its main EM index, having taken the view that access to the Chinese market was still too difficult. A reversal of that position would follow last Tuesday’s announcement that FTSE was creating two “transitional” EM indices, which will include Chinese A shares. The move is designed to pave the way towards the inclusion of A shares in global FTSE benchmarks over time. Once MSCI and FTSE start giving PRC shares their full attention, global investors will have to put more capital into the Shenzhen and Shanghai bourses to keep pace with the market standards for EM returns. “There are trillions of dollars of institutional money tracking MSCI and FTSE indices and, if it happens, then it’s going to bring massive volume,” said Benoit Dethier, European head of Citigroup’s Asia flow desk. “Stock Connect is the easiest way to access the market for many investors.” Reclassification decisions are based on size, liquidity and accessibility. The mainland market is big and liquid, but money managers rightly complain that, beyond existing tightly managed quota systems, it is inaccessible to foreigners. MSCI considered A shares for inclusion a year ago, but ultimately opted against it because of constraints the qualified foreign institutional investor (QFII) programmes posed and the limitations related to repatriation of capital. “The real challenge is liquidity. You can’t include a market in an international benchmark index if you can’t get access to liquidity. Because QFII is a finite resource, you would get a lot of tracking error,” said Shane Edwards, global head of equity derivatives at UBS. The launch of Shanghai-Hong Kong Stock Connect in November, however, has made the mainland equity market more open to offshore investors than before, correcting some of the liquidity and access problems MSCI described last June. Typically, daily quotas on the trading link are far from full. However, authorities calculate the measure on a net basis, meaning that a significant rush of two-way activity can go through without using much of the quota. Stock Connect also solves another big problem: when investors sell stocks on the platform, they can now repatriate the money with ease. As such, many market participants say they believe MSCI will opt to include China-listed shares in EM benchmark products next month. They are unsure, however, about the ultimate weighting to be assigned to those securities and how quickly that weighting will be phased in. FTSE, for its part, said A shares would comprise about 5% of its new transitional indices before rising to 32% when they “become fully available to international investors”, according to last week’s release. This will mean that the entire universe of Chinese stocks (including B shares and H shares) will make up 50% of the FTSE Emerging Index. At MSCI, China’s A shares would take a more direct path to the benchmark than shares listed in other countries. Typically, new regions are first included in a benchmark for frontier markets, which has lower accessibility requirements than EM. However, the size and liquidity of China’s market mean it will go straight to EM. The Shanghai and Shenzhen bourses combined represent the world’s third-largest equity market in terms of market capitalisation, and